Question 1
Diamond & He (2014) observed that debt overhang theory depicts that companies with expansion and growth option should desist from using debts that cannot be renegotiated or long-term debt because the benefits and profits of a good project will partially go to settle the bills. When long-term investments are reclassified as short-term, the company will surge the current assets and consequently the current ratio increases. The current ratio depicts the relationship between current liabilities and current assets. Ross Lipstick Company reclassified long-term investment that upsurges the current assets. The reclassifying of long-term assets by Ross Lipstick Company improved the current ratio of the present assets that the company has. By attaining higher current ratio, Ross Lipstick Company becomes sturdier financially. On the other hand, when a company has a healthier current ration, it does mirror the robust financial position of the Ross’s Lipstick Company provided that the ratio is legit. Conversely, how assets are categorized (non-current and current), I not affected based on the financial position.
Wu, Wei, Zhang, Chen & Peng (2015) observed that businesses which have debt ratings tend to have great admittance to public bonds markets and document which these companies access more liability. A debt rating indicator variable (Debt Rating) is used to capture a firm’s access to the bond market. When a company is assigned a debt rating of It implies that the company has a standard debt rating if it has a zero score the company has poor debt ratings. To capture the variability of a business it is important to the earning volatility of Ross’s Lipstick Company, that is determined as a standard deviation of the EBIT to assets ratio in the previous five years ( Wu et al. 2015) .
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Question 2
Cai & Zhang (2011) in contrast, stresses “liquidation risk” that is intrinsic in short-term debt: companies that have development potential but has uncertain cash flows can result in loss of their growth option and short-term debt. Reclassifying a long-term investment as current to fulfill a debt treaty does not imply that the manager of Ros Company is unethical. The manager may be honest with the action of selling an investment to meet the obligation. In the scenario the manager's action is justifiable.
Reclassifying the investments of Ross’s Lipstick Company back to long-term may create a picture that the managers of the company are playing a shell game. Though, case study depicts that after the first reclarification enhanced the current ratio. Under these conditions, the company should not make their investment ( Diamond & He, 2014) . The manager should hold onto the investment beyond the single year. Therefore, there is a necessity to reclassify them as long-term. Therefore, the deed of the manager is justifiable. This scenario depicts how grey accounting issue works. In the scenario, the debt treaty relies on the current ratio, that is afflicted by an asset organization that managers merely regulate by their intents since the true intention of the manager can be ascertained by certainty, it will be much difficult to present evidence that managers are behaving unethically.
The survey conducted by Cai & Zhang, (2011) depicts that large percentage of chief financial officers have some preferences for short-term debt “when short-term interest rates are low compared to long-term rates.” Term spread obliges as a delegation for investments opportunities ( Diamond & He, 2014) . A high term spread depicts healthy economic prospects that may lead to an upsurge in debt maturity if a company borrows long to finance investments ( Diamond & He, 2014) . The term spread is extremely negatively linked with the credit score which measures default risks. Hence, it can be contended that the term spread proxies for debt markets situations largely.
References
Cai, J., & Zhang, Z. (2011). Leverage change, debt overhang, and stock prices. Journal of Corporate Finance , 17 (3), 391-402.
Diamond, D. W., & He, Z. (2014). A theory of debt maturity: the long and short of debt overhang. The Journal of Finance , 69 (2), 719-762.
Wu, G., Wei, X., Zhang, Z., Chen, Q., & Peng, L. (2015). A Graphene‐Based Vacuum Transistor with a High ON/OFF Current Ratio. Advanced Functional Materials , 25 (37), 5972-5978.
